Chapter 6 - Financing Techniques for Short Sellers

Abstract

This chapter explains how lending markets allow traders to finance both long and short positions. The repo market permits traders to finance both long and short positions in a wide variety of bonds. Traders need to borrow a security when they sell short and the trader delivers the borrowed security to the buyer on the settlement date. The proceeds of the short sale provide cash to secure the loan of the bonds and eventually, the trader buys back the security and returns the security to the lender. Dealers and hedge funds use the repo and reverse repo market to finance long and short positions in a variety of bonds. Institutional investors such as pension funds, mutual funds, nonfinancial corporations, and government organizations invest in repo as a short-term investment with credit enhancement from the bond collateral provided by the counterparty. The stock loan market similarly provides access to financing of long and short stock positions and it closely resembles the reverse repo market. Most stock loans are collateralized with cash but some 2% are collateralized with US Treasury Securities. And stock lending trades are typically collateralized with cash equal to 102% of the value of the stock loaned for US issues and 105% of the value of international stock issues. Finally, leasing and other negotiated financing provide financing of long and short commodity positions. For this, warehouse receipts issued in the United States under the protection of the US Warehouse Receipts Act of 2000 are generally used, which are negotiable, can be sold, used as collateral for loans, or lent to traders that must make deliveries.